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How To Use Put/Call Ratios To Identify Potential Moves In Individual Stocks

By Daniel Beighley

 

When I make my trading
decisions, I like to know everything I can about what I’m getting into. I place
a lot of emphasis on my charts, but they don’t always tell the whole story.
Using the put and call ratios of options can reveal a lot about the potential
price action for common stock.

In this lesson I will cover two
different forms of the Put/Call Ratio. The first is the All Equities Put/Call
Ratio. This is a popular sentiment indicator that is best used to identify
shifts in the general market direction. The second is the Put and Call Ratios
for individual stocks. This combines the Put/Call and Call/Put relationships to
identify short-term support and resistance zones for the common stock.

All Equities Put/Call Ratio

Ever since 1997 the Chicago Board Options
Exchange (CBOE) has made public their Put/Call Volume Ratio. This statistic has
proven to be one of the most effective ways a trader can measure the sentiment
of the markets. The basic function of the indicator portrays the relationship
between the number of option positions taken in anticipation of a stock falling,
the puts, over the number of option positions taken in anticipation of a stock
rising, the calls. This measurement has proven to be most effective from a
contrarian perspective. When an exceedingly disproportionate number of puts
outnumber the calls, the market tends to rally. In other words, the “herd” is
most often wrong.

By comparing these two graphs,
you can see that every time a spike in puts occurs the market counters by
rising. The only exception here happens at point “B,” when the S&P manages only
a slight gain before resuming its downtrend. The key points here are the spikes.
There isn’t any precision involved. The only thing that is clear is the fact
that when large amounts of pessimism via puts enter the market, a rally is
likely to follow. Notice the massive spikes at point “C,” which served as a
precursor to the rally off our April lows. The most recent spike is from early
last July when the market reacted with a light rally.

The psychology behind this is
found somewhere within why the masses are generally wrong. One interpretation is
that the bulk retail options investors represent the “dumb money” and are going
after what appears to be a certain decline in the market. At the same time,
“smart money” is buying puts to hedge their long positions. When the market goes
bullish, short-sellers are forced to cover their positions, adding to a rally.
Another explanation is from the supply-and-demand theory. When heavy selling
pressure has already hit the market, there is little left to bring it further
down, thus, an up-trend. One of the main reasons why this is an effective
sentiment indicator is the fact that it tracks actual money in play, as opposed
to an opinion poll or less quantifiable theory. The charts are what they are,
and the Put/Call Ratio is a “must follow” indicator.

Put and Call Ratios for
Individual Stocks

To a less certain degree, volume ratios for
individual stocks can be an effective way to identify setups. Like the All
Equities Put/Call Ratio, the ratios of individual stocks are used as a sentiment
indicator. Individual stocks are typically more volatile and trade in a wider
range than the overall market and are, therefore, less predictable. It pays to
know how a particular stock behaves in certain environments, and using the data
from the open interest of options can be a great way to monitor the common
stock.

Open Interest on Options for Siebel Systems (SEBL). 

Currently trading around $35 a share:

* NOTE:  A Call/Put Ratio is used for options
above current stock price (marked in blue) and a Put/Call Ratio is used for
options below current stock price (marked in black.) This creates a standard to
better gauge the volume action. 

This data table for the options
volume of Siebel Systems (SEBL) is telling me that there is an overwhelming
number of positions held in favor of the stock declining in value. Without even
using the ratios, I can see  the volume is heavily in favor of  the puts. Right
off the bat I know that the sentiment is down for this stock. Using the ratios
gives me an advantage for easily identifying the sentiment for each price level
with a single number. Ideally, I’d like to know the actual short and long
interest for the common stock, but that information isn’t made public until a
month later. Neutral sentiment for the options ratios is roughly considered to
be around 2.0. In other words, two calls for every put on the upside, and two
puts for every call on the downside. Levels above 20 are beginning to show
extreme levels of sentiment either bearish or bullish.
I know from viewing this data that there is neutral sentiment on the downside of
this stock until I get to the Strike Price of 27. This will serve as short-term
support for the stock. On the upside, sentiment is roughly neutral to the Strike
Price of 42.50, where the stock will find short-term resistance.

This data table also tells me
that there are an exorbitant amount of traders who are placing puts on the
downside. With the contrarian perspective, this is one of the factors that can
lead to a “squeeze” of short sellers. The “squeeze” occurs when short sellers
are forced to cover their positions due to a rising price in the common stock.
Options traders and common stock traders move identically with sentiment,
therefore, I can assume there are a great number of shares held short for this
stock. Because it appears the “herd” has shifted itself to the short side, I’m
going to expect the stock will have a tough time falling below the support zone
of 27. Also, long puts on the downside require market makers to buy shares of
common stock to remain hedged. Short squeezes are not easy things to predict,
but any bullish event could cause shorts to run for cover, driving the price up
with new buying pressure. Tracking the put and call ratios gives me a heads up
for how the price action may play out.

The reasoning behind the price
action for individual stocks is similar to that behind the All Equities Put/Call
Ratio. The “herd” is often wrong. If you follow the options volume for
individual stocks you will notice that the “smart money” leads the action as it
quietly settles into the market, and the “dumb money” usually ends the trend as
masses flock in to create vulnerable support and resistant zones for squeezes. 
Another way to look at this is from the perspective of supply and demand. When
large amounts of selling pressure are already factored into the market, there
may not be much left to bring the prices down further.

Another thing the options data
gives me is a new support zone I won’t find on a typical bar chart. Because SEBL
has never traded below 22.95 there is no way I can tell from looking at the
chart where the price may consolidate if it falls below. From looking at the
options data I can see that there is congestion at the 20, 17.50 and 15 strike
prices. These areas are new zones of support I won’t find anywhere else!  

Calculating the ratios for
individual stocks can take some time, though with spreadsheets, it’s really just
a simple task that can give a trader a good basis for making decisions. The data
can be found on Yahoo!, and the CBOE’s cboe.com
provides a good resource for the All Equities Put/Call Ratio. As I said before,
it pays to know a stock well. Gauging options volume by eye can be an effective
way to stalk for potential price action, but using the ratios provides for an
easy way to monitor the sentiment. Playing the markets is not easy money. It is
important to do your homework, and even more important not to get caught up with
the “herd.”

Danileb@tradingmarkets.com

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